Step-by-step tax return adjustments for the employee retention credit
Can you please see below and provide your thoughts on a differing position:
§3134(e) states that rules similar to §280C(a) will apply. §280C discusses how expenses relating to tax credits received are not deductible. This part I agree with.
The part that I disagree with is whether this affects the AAA account and basis. The credits discussed under §280C are income tax credits. ERC is a payroll tax credit. The method that ERC makes the wages non-deductible is from the book reduction of wages. AAA and retained earnings should be very close to each other, other than differences in book vs tax basis for things such as depreciation and reserve accounts.
Here are two examples of the thought process.
• The R&D tax credit has a similar addback provision under §280C(c). Let’s assume that $100,000 were expended, resulting in a $20,000 credit. I agree here that the $20,000 credit should be a reduction to AAA. The net affect to AAA is a reduction of $100,000. If looking at AJEs for a C corporation, the $20,000 credit would look like this:
Tax Expense ($20,000)
Since this is a pass-through, there is no tax expense. The S Corporation would not receive the cash; instead, its shareholders would receive an offset to their tax liabilities.
• For 50% meals, the non-deductible portion has still been expended by the taxpayer. So, $1,000 of meals expended results in a $500 deduction but a $1,000 reduction of AAA.
Where the ERC is different is that the credit is for payroll tax, and the S Corporation receives the cash. Let’s assume that wages are $100,000, and the ERC is $20,000. Once the ERC is received, the journal entry would look similar to this:
The end result would be a net expense for wages of $80,000.
In the above R&D example, books show an expense of $100,000, and the tax return shows a deduction of $80,000. The $20,000 difference is non-deductible.
For the ERC example, both books and the tax return show the same amount of expense for $80,000. There is no difference between the book expense and the tax return deduction, and this is why I believe there is no reduction to AAA.
Appreciate your response.